Granite Construction - 10-Q quarterly report FY

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 introduces a framework for measuring fair value and expands required disclosure about fair value measurements of certain assets and liabilities. We adopted SFAS 157 as of January 1, 2008, and the impact of adoption was not significant. The FASB has deferred the effective date of SFAS 157 for all non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis, to fiscal years beginning after November 15, 2008. We are currently assessing the impact on our financial statements of SFAS 157 as it pertains to non-financial assets and liabilities measured on a non-recurring basis.

SFAS 157 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. SFAS 157 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

Level 1 - Quoted prices in active markets for identical assets or liabilities.

Level 2 - Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

We utilize the active market approach to measure fair value for our financial assets and liabilities.

We have no financial liabilities measured at fair value on a recurring basis.  Assets measured at fair value on a recurring basis are summarized below and included in short-term marketable securities at September 30, 2008.

Inventories, net consist primarily of quarry products, asphalt and fuel valued at the lower of average cost or market.

We are participants in real estate entities through our Granite Land Company subsidiary (“GLC”). Generally, each entity is formed to accomplish a specific real estate development project. We have determined that certain of these entities are variable interest entities as defined by FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities (“FIN 46(R)”). Accordingly, we have consolidated those entities for which we have determined that we are the primary beneficiary.

Due to the downturn in the residential housing market, most notably in California, together with tighter credit markets, we assessed whether our investments in residential and commercial projects were impaired. The carrying amounts of such real estate development assets are evaluated for recoverability in accordance with Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets   (“SFAS 144”). A real estate development asset is considered impaired when its carrying amount is greater than the undiscounted future net cash flows the asset is expected to generate. The carrying value of impaired real estate development assets is generally determined based on the sum of the discounted cash flows expected to result from the eventual disposal of the asset. Based on our evaluations, we recognized a pretax, non-cash impairment charge of $4.5 million in the second quarter of 2008 on assets classified as real estate held for development and sale. We recorded the charge in cost of revenue in our consolidated statements of income in our Granite Land Company segment.

Impairment assessment inherently involves judgment as to assumptions about expected future cash flows and the impact of market conditions on those assumptions. Future events and changing market conditions may impact our assumptions as to sales prices, costs, holding periods or other factors that may result in changes in our estimates of future cash flows. Although we believe the assumptions we used in testing for impairment are reasonable, changes in any one of our assumptions could produce a significantly different result.

Our agreements with our partners in our real estate entities define the management role of each partner and each partner’s financial responsibility in a residential and commercial project. If one of our partners is unable to make its required contribution or fulfill its management role, we may be required to assume full financial and management responsibility for completion of the project.

At September 30, 2008, the entities we have consolidated were engaged in residential and commercial development projects with total assets ranging from approximately $0.4 million to $27.1 million.

The breakdown by type and location of our real estate held for development and sale is summarized below:

Additionally, at September 30, 2008 we had $16.1 million in real estate held for use included in property and equipment on our condensed consolidated balance sheet related to consolidated real estate entities. Of the combined total of real estate held for development, sale and use of $68.3 million, approximately $59.0 million was pledged as collateral for the obligations of the real estate entities. This debt, which totaled $25.4 million at September 30, 2008 is non-recourse to Granite. Our proportionate share of the results of these entities varies depending on the ultimate profitability of the entities. 

We account for our share of the operating results of real estate entities in which we have determined we are not the primary beneficiary in “investments in affiliates” in our condensed consolidated balance sheets and in “other income (expense)” in our condensed consolidated statements of income. At September 30, 2008, these entities were engaged in real estate development projects with total assets ranging from approximately $6.3 million to $52.5 million. Our proportionate share of the operating results of these entities varies depending on the ultimate profitability of the entities. At September 30, 2008 we had approximately $20.2 million recorded on our condensed consolidated balance sheet related to our investment in these real estate entities.

The following table provides summarized financial information on a combined 100% basis for our real estate affiliates accounted for under the equity method:

Substantially all the assets of these entities are classified as real estate held for sale.  All outstanding debt of these entities is non-recourse to Granite.

The breakdown by type and location of our interest in these real estate ventures is summarized below:

We participate in various construction joint ventures. Generally, each construction joint venture is formed to accomplish a specific project and is jointly controlled by the joint venture partners. The joint venture agreements typically provide that our ownership share in any profits and assets, and our respective share in any losses and liabilities that may result from the performance of the contract are limited to our stated percentage equity ownership in the project. Although each construction joint venture’s contract with the project owner typically requires joint and several liability among the joint venture partners, our agreements with our joint venture partners provide that each partner will assume and pay its full proportionate share of any losses resulting from a project.

We have determined that certain of these construction joint ventures are variable interest entities as defined by FIN 46(R). Accordingly, we have consolidated those joint ventures where we have determined that we are the primary beneficiary. At September 30, 2008, the construction joint ventures we have consolidated were engaged in construction projects with total contract values ranging from approximately $11.5 million to $487.6 million. Our proportionate equity ownership share of the consolidated joint ventures ranges from 40% to 99%.

Consistent with Emerging Issues Task Force Issue 00-01, Investor Balance Sheet and Income Statement Display under the Equity Method for Investments in Certain Partnerships and Other Ventures we account for our equity ownership share of the operating results of construction joint ventures in which we have determined we are not the primary beneficiary on a pro rata basis in the condensed consolidated statements of income and as a single line item in the condensed consolidated balance sheets. At September 30, 2008, the joint ventures in which we held an equity ownership share but are not the primary beneficiary were engaged in construction projects with contract values ranging from approximately $94.4 million to $935.3 million. Our proportionate equity ownership share of these joint ventures ranges from 20% to 40%.

We also participate in various “line item” joint venture agreements under which each partner is responsible for performing certain discrete items of the total scope of contracted work. The revenue for these discrete items is defined in the contract with the project owner and each partner assumes the profitability risk associated with its own work. All partners in a line item joint venture are jointly and severally liable for completion of the total project under the terms of the contract with the project owner. There is not a single set of books and records for a line item joint venture. Each partner accounts for its items of work individually as it would for any self-performed contract. We account for our portion of these contracts as a project in our accounting system and include receivables and payables associated with our work on our condensed consolidated balance sheets.

Although our agreements with our joint venture partners for both construction joint ventures and line item joint ventures provide that each partner will assume and pay its share of any losses resulting from a project, if one of our partners is unable to make its required contribution, we would be fully liable under our contract with the project owner. Circumstances that could lead to a loss under our joint venture arrangements beyond our proportionate share include a partner’s inability to contribute additional funds to the venture in the event the project incurs a loss, or additional costs that we could incur should a partner fail to provide the services and resources toward project completion that had been committed to in the joint venture agreement. At September 30, 2008, approximately $600.0 million of work representing our partners’ share of unconsolidated and line item joint venture contracts in progress had yet to be completed.

Balances of major classes of assets and allowances for depreciation, depletion and amortization are included in property and equipment, net on our condensed consolidated balance sheets as follows:

Restricted common stock, representing approximately 182,000 shares and 203,000 shares for the three and nine months ended September 30, 2008, respectively, and approximately 59,000 shares for the nine months ended September 30, 2007, has been excluded from the calculation of diluted common shares outstanding because their effect would be anti-dilutive.

Our wholly-owned subsidiary Granite Construction Company (“GCCO”) is one of approximately 100 to 300 defendants in eight active California Superior Court lawsuits. Of the eight lawsuits, five were filed against GCCO in 2005 and three were filed against GCCO in 2006, in Alameda County ( Molina vs. A-1 Aggregates, et al.; Dominguez vs. A-1 Aggregates, et al.; Cleveland vs. A. Teichert & Son.; Guido vs. A. Teichert & Son, Inc.; Williams vs. A. Teichert & Son, Inc.; Horne vs. Teichert & Son, Inc.; Kammer vs.A-1 Aggregates, et al.; and Solis vs. The 3M Company et al.). Each lawsuit was brought by a single plaintiff who is seeking money damages by way of various causes of action, including strict product and market share liability, and alleges personal injuries caused by exposure to silica products and related materials during the plaintiffs’ use or association with sand blasting or grinding concrete. The plaintiff in each lawsuit has categorized the defendants as equipment defendants, respirator defendants, premises defendants and sand defendants. We have been identified as a sand defendant, meaning a party that manufactured, supplied or distributed silica-containing products. Our preliminary investigation revealed that we have not knowingly sold or distributed abrasive silica sand for sandblasting, and therefore, we believe the probability of these lawsuits resulting in an incurrence of a material liability is remote. We have been dismissed from sixteen other similar lawsuits.

The Hiawatha Light Rail Transit (“HLRT”) project was performed by Minnesota Transit Constructors (“MnTC”), a joint venture that consisted of GCCO and other unrelated companies.  GCCO was the managing partner of the joint venture, with a 56.5% interest.  The Minnesota Department of Transportation (“MnDOT”) is the contracting agency for this federally funded project.  The Metropolitan Council is the local agency conduit for providing federal funds to MnDOT for this HLRT project.  MnDOT and the U.S. Department of Transportation Office of Inspector General (“OIG”) each conducted a review of the Disadvantaged Business Enterprise (“DBE”) program maintained by MnTC for the HLRT project.  In addition, the U.S. Department of Justice (“USDOJ”) is conducting an investigation into compliance issues with respect to MnTC’s DBE Program for the HLRT project.  MnDOT and the OIG (collectively, the “Agencies”) have initially identified certain compliance issues in connection with MnTC’s DBE Program and, as a result, have determined that MnTC failed to meet the DBE utilization criteria as represented by MnTC.  Although there has been no formal administrative subpoena issued, nor has a civil complaint been filed in connection with the administrative reviews or the investigation, MnDOT has proposed a monetary sanction of $4.3 million against MnTC and specified DBE training for personnel from the members of the MnTC joint venture as a condition of awarding future projects to joint venture members of MnTC on MnDOT and Metropolitan Council work.  MnTC is fully cooperating with the Agencies and the USDOJ and, on July 2, 2007, presented its detailed written response to the initial determinations of the Agencies as well as the investigation by the USDOJ.  We have yet to receive a formal reply from the Agencies or the USDOJ, those entities instead preferring to engage in informal discussions in attempt to resolve the matter. We cannot, however, rule out the possibility of a civil or criminal actions being brought against MnTC or one or more of its members which could result in civil and criminal penalties.

The I-494 project was performed by a joint venture (“JV”) that consisted of GCCO and another unrelated party.  GCCO was the managing partner of the JV, with a 60% interest.  MnDOT is the contracting agency for this federally funded project.  MnDOT conducted a review of the DBE program maintained by the JV for the I-494 project.  MnDOT has initially identified certain compliance issues in connection with the JV’s DBE program, and as a result, has determined that the JV failed to meet the DBE utilization criteria as represented by the JV.  On August 28, 2008 this matter was resolved by agreement between the parties without any final determination of any violations by MnDOT or any acknowledgement by the JV, or any member, of any violations.  The settlement does not impose any future obligations or restrictions on the JV or any of its members.

GCCO and our wholly-owned subsidiary, Granite Northwest, Inc. are the members of a joint venture known as Yaquina River Constructors (“YRC”) which is currently constructing a new road alignment of US Highway 20 near Eddyville, Oregon under contract with the Oregon Department of Transportation (“ODOT”).  The project involves constructing seven miles of new road through steep and forested terrain in the Coast Range Mountains.  During the fall and winter of 2006, extraordinary rain events produced runoff that overwhelmed erosion control measures installed at the project and resulted in discharges to surface water in alleged violations of the stormwater permit.  The Oregon Department of Environmental Quality has issued notices of violation and fine of $240,000 to YRC for these alleged violations which have been resolved by an agreement and final order entered into on July 25, 2008.  The Oregon Department of Justice is, however, still conducting a criminal investigation in connection with stormwater runoff from the project.  YRC and its members are fully cooperating in the investigation, but YRC does not know whether criminal charges or civil lawsuit, if any, will be brought or against whom. Therefore, we cannot estimate what if any criminal or civil penalty or conditional assessment will result from this investigation.

In August 2003, the City of Sacramento and GCCO entered into a contract for the construction of a public work improvement referred to as West El Camino Widening and Bridge Replacement Project.  During the course of the project, the City disputed GCCO’s entitlement to compensation for certain work.  GCCO excavated significantly more material than the City’s engineer estimated and represented as a bid item in the contract. The City maintains the engineer’s estimate contained in the contract was substantially less than it should have been due to a clerical error.  GCCO filed a complaint in the California Superior Court, County of Sacramento, against the City in November 2006 seeking payment in excess of $750,000 for the actual quantity of material excavated which the City refuses to pay.  The City also claims GCCO submitted a false bid when GCCO offered its bid to the City using a quantity for the material excavation GCCO knew to be incorrect.  On July 23, 2008 the City filed a cross-complaint against GCCO to assert false representation allegations and seek relief pursuant to the California False Claims Act and assert other fraud based causes of action.  The City’s cross-complaint seeks $10,000 for each false claim, restitution and disgorgement of all earnings, punitive damages, attorney fees, costs and interest.  GCCO disputes certain material facts as suggested by the City and believes the City’s entitlement to the relief sought under the causes of action pled, including the California False Claims Act, is remote.  GCCO will vigorously defend itself against the allegations raised.

We are a party to a number of other legal proceedings arising in the normal course of business.  From time to time, we receive inquiries from public agencies seeking information concerning our compliance with government construction contracting requirements and related laws and regulations. We believe that the nature and number of these proceedings and compliance inquiries are typical for a construction firm of our size and scope. Our litigation typically involves claims regarding public liability or contract related issues. While management currently believes, after consultation with counsel, that the ultimate outcome of such proceedings and compliance inquiries which are currently pending, individually and in the aggregate, will not have a material adverse effect on our financial position or overall trends in results of operations or cash flows, litigation is subject to inherent uncertainties. Were an unfavorable ruling to occur, there exists the possibility of a material adverse impact on the results of operations, cash flows and/or financial position for the period in which the ruling occurs. While any one of our pending legal proceedings is subject to early resolution as a result of our ongoing efforts to settle, whether or when any legal proceeding will resolve through settlement is neither predictable nor guaranteed.

Our three reportable segments based on similar economic characteristics as defined in Statement of Financial Accounting Standards No. 131, Disclosures about Segments of an Enterprise and Related Information (“SFAS 131”) are Granite West; Granite East; and Granite Land Company (“GLC”).

Granite West is comprised of decentralized branch offices in the western United States that perform various heavy civil construction projects with a large portion of the work focused on new construction and improvement of streets, roads, highways and bridges as well as site preparation for residential and commercial development and sales of construction materials. Each branch reports under one of three operating groups: Northwest, Northern California and Southwest.   Although most Granite West projects are started and completed within a year, the division also has the capability of constructing larger projects and at September 30, 2008 had six such active large projects, each with total contract revenue greater than $50.0 million. All of our revenue from the sale of construction materials is generated by Granite West which mines aggregates and operates plants that process aggregates into construction materials for internal use and for sale to others. These activities are vertically integrated into the Granite West business, providing both a source of profits and a competitive advantage to our construction business.

Granite East operates in the eastern portion of the United States with a focus on large, complex infrastructure projects, primarily east of the Rocky Mountains. With its division office in Lewisville, Texas, Granite East operates out of three regional offices: the Central Region, based in Lewisville, Texas; the Southeast Region, based in Tampa, Florida; and the Northeast Region, based in Tarrytown, New York.  Granite East construction contracts are typically greater than two years in duration.

The accounting policies of the segments are the same as those described in the Summary of Significant Accounting Policies contained in our 2007 Annual Report on Form 10-K. We evaluate performance based on operating profit or loss (excluding gain on sales of property and equipment), and do not include income taxes, interest income, interest expense or other income (expense). Unallocated other corporate expenses principally comprise corporate general and administrative expenses.

A reconciliation of segment operating income to consolidated income before tax and minority interest is as follows:

In January 2008, we acquired certain assets and assumed certain liabilities of a construction materials supplier in Nevada for a purchase price of approximately $14.0 million in cash. The effect of the operating results of the acquired business on our consolidated operating results was not material. The estimated fair value of the assets acquired approximated the purchase price; therefore, no goodwill was recorded.

In 2007, our Board of Directors authorized us to purchase, at management’s discretion, up to $200.0 million of our common stock. During the nine months ended September 30, 2008, we purchased 1.4 million common shares for a total of $43.2 million under this share purchase program. From the inception of this share purchase program in 2007 through September 30, 2008, we have purchased a total of 3.8 million common shares for an aggregate cost of $135.9 million. All shares were retired upon acquisition. At September 30, 2008, $64.1 million of the $200.0 million authorization was available for future common share purchases.